The Jeopardy of Settlements in Insolvency Cases

The Supreme Court in a recent order recommended that the Insolvency and Bankruptcy (Application to the Adjudicating Authority) Rules, 2016 be amended to allow for settlement between an individual debtor and creditor after an insolvency petition has been accepted.

With respect, allowing individual settlements after insolvency proceedings have commenced will be contrary to the special nature of insolvency proceedings, which are mandatory and collective proceedings, and will render injustice to the larger constituency of creditors.

When a creditor is owed a debt by a company, it has a right to recover the debt when it falls due. To enable such debt collection, the law provides a creditor with two options. The creditor may institute an individual enforcement action that affects only the parties to the debt, and only up to the amount of that debt. This includes debt recovery proceedings under the Code of Civil Procedure, 1908, the Recovery of Debts due to Banks and Financial Institutions Act, 1993 (RDDBFI Act) and the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI Act). Alternatively, the creditor may institute insolvency proceedings. Here, the creditor institutes proceedings as a member of a class of stakeholders of the company, that is, creditors as a whole. Thus, this is not a lis (dispute) between that creditor and the debtor, but it is a collective proceeding. While one of the functions of insolvency proceedings is undoubtedly to enable debt collection, it is to do so through a collective and mandatory procedure and for the combined interests of all creditors. When a creditor chooses to exercise this second option, they commit to becoming a part of collective proceedings which effect all the stakeholders of the company.

Understandably, the remarkable swiftness of the NCLTs in disposing off petitions under the Insolvency and Bankruptcy Code, 2016 (the Code) and the exceptional coercive powers of insolvency proceedings make it an attractive procedure for creditors to enforce their debts. However, when the creditor opts for collective proceedings, and an insolvency petition is admitted, there are significant costs to the company and all its stakeholders. There is an automatic moratorium on all other creditors’ individual enforcement actions, the power of the board of directors of the company is suspended and an insolvency professional exercises all significant management and oversight powers over the company. To allow an individual creditor to settle with the debtor once this entire machinery has been put into force would subvert the goals of insolvency law, as explained below:

First, allowing individual settlements would mean placing interests of one creditor over the interests of all the other creditors who were affected by the institution of the proceedings. So, when the company doesn’t have enough funds to pay all its creditors, it will pay the person who initiated the insolvency proceedings, at the expense of those who didn’t. Thus, an important aspect of insolvency proceedings, which requires taking into account all creditors’ interests will be compromised.

Secondly, if creditors know that the institution of insolvency proceedings will enable them to gain settlement of their individual debts, it may result in a situation where all creditors will race to bring an insolvency petition and ‘grab’ whatever settlement they can from the company. The company may choose to pay out individual debts and cause its financial position to worsen, just to retain control even when it may be more efficient in the long run for all creditors to negotiate a longer term of repayment or haircut on their debts so that the company can return to financial health and service all creditors’ needs. Allowing such settlements will then compromise another important goal of insolvency proceedings, attempting to maximize the value of the company for all stakeholders.

With this background in mind the provisions of the Code do not provide any scope for settlement of proceedings by an individual debtor. Instead, the Code provides a clear and mandatory procedure on what may be done once the proceedings have commenced. Thus, once the insolvency proceedings are triggered, the only kind of settlement that can be allowed is when the committee of creditors decides to approve a resolution plan. In such circumstances, there is no scope for subordinate legislation under the Code to provide a procedure to conflict with the one provided under the Code, and as I have argued above, it will not be desirable to do so.

Creditors must, therefore, use individual enforcement proceedings where they are not prepared to accept the consequences of invoking insolvency. In this regard, the courts and the government should work to make individual enforcement mechanisms more efficacious, and speedy, rather than allow insolvency proceedings to become tools of individual debt collection.

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